Pimco’s Gross Warns of Leverage Risk in Corporate Bonds

By Michael Aneiro

Pimco’s Bill Gross, rarely shy about sharing his views on the bond market, penned a piece in today’s Financial Times that offers a sharp rebuke of the inherent leverage in corporate bond markets today and says investors are largely unaware of the consequent risks. Gross compared today’s corporate bond situation to that found immediately before the credit crisis in constant proportion debt obligations (CPDOs), structured finance innovations that leveraged credit spreads while receiving triple-A credit ratings but subsequently suffered massive losses:

Today there is s similar CPDO character to many risk markets, and corporate credit serves as a useful illustration of a broader phenomenon. While spreads are not as narrow and prices as high as five years ago, hundreds of billions of investment dollars are pouring into corporate bonds on the assumption that credit spreads are the least overpriced asset class in a world of near-zero sovereign interest rates.

Gross, steward of the behemoth Pimco Total Return (PTTRX) bond fund, says that sovereign debt rating cuts have accelerated the “gold rush” into corporate credit and fueled a belief that some multinational companies are safer bets than some governments. (Barron’s and this blog have written at length about uncommon risks in today’s corporate bond market, most recently here and here.)

“Yet investors should note that the appeal of corporate credit rests on a tenuous foundation much as CPDOs did in 2007,” Gross writes, saying such markets work on a mean-reverting basis that requires further risk asset purchases from a cash reserve. In the case of corporate bonds right now, that means ongoing Federal Reserve intervention is an absolute requirement:

[I]nvestors should understand that aggregate credit outstanding, which in the US totals $45tn… is levered at the same 10 or 15 to 1 ratio as were CPDOs. The Fed’s monetary base – its cash reserve – approximates $4tn. This has permitted the expansion and ultimate maintenance of $54tn of sovereign, corporate and household credit…. With such substantial leverage, investors should question the sustainability of existing risk spreads if monetary policy fails to sustain economic growth rates.

Gross says an unlevered corporate bond portfolio won’t be subjected to the massive price losses that CPDO’s saw in 2008, but the economic growth assumptions underpinning the two are remarkably similar in their leverage. He closes with a more muted nod to the “black swan” imagery of Nassim Taleb signaling outlier events:

Investors in risk markets under the assumption of minimal price risk should be wary of historical white swan investments with “grey” swan potential.

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